# Economic Efficiency, Government Price Setting, and Taxes

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1 CHAPTER 4 Economic Efficiency, Government Price Setting, and Taxes Modified by: Changwoo Nam 1 Economic Efficiency, Government Price Setting, and Taxes A legally determined maximum price that sellers may charge. A legally determined minimum price that sellers may receive. 2

2 Consumer Surplus and Consumer Surplus The difference between the highest price a consumer is willing to pay for a good or service and the price the consumer actually pays. The additional benefit to a consumer from consuming one more unit of a good or service. 3 Consumer Surplus and Consumer Surplus FIGURE 4-1 Deriving the Demand Curve for Chai Tea With four consumers in the market for chai tea, the demand curve is determined by the highest price each consumer is willing to pay. For prices above \$6, no tea is sold because \$6 is the highest price any consumer is willing to pay. For prices of \$3 and below, every one of the four consumers is willing to buy a cup of tea. 4

3 Consumer Surplus and Consumer Surplus FIGURE 4-2 Measuring Consumer Surplus Panel (a) shows the consumer surplus for Theresa, Tom, and Terri when the price of tea is \$3.50 per cup. Theresa s consumer surplus is equal to the area of rectangle A and is the difference between the highest price she would pay \$6 and the market price of \$3.50. Tom s consumer surplus is equal to the area of rectangle B, and Terri s consumer surplus is equal to the area of rectangle C Total consumer surplus in this market is equal to the sum of the areas of rectangles A, B, and C, or the total area below the demand curve and above the market price. In panel (b), consumer surplus increases by the shaded area as the market price declines from \$3.50 to \$ Consumer Surplus and Consumer Surplus FIGURE 4-3 Total Consumer Surplus in the Market for Chai Tea The demand curve tells us that most buyers of chai tea would have been willing to pay more than the market price of \$2.00. For each buyer, consumer surplus is equal to the difference between the highest price he or she is willing to pay and the market price actually paid. Therefore, the total amount of consumer surplus in the market for chai tea is equal to the area below the demand curve and above the market price. Consumer surplus represents the benefit to consumers in excess of the price they paid to purchase the product. 6

4 Consumer Surplus and The additional cost to a firm of producing one more unit of a good or service. The difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. 7 Consumer Surplus and FIGURE 4-4 Measuring Panel (a) shows Heavenly Tea s producer surplus. Producer surplus is the difference between the lowest price a firm would be willing to accept and the price it actually receives. The lowest price Heavenly Tea is willing to accept to supply a cup of tea is equal to its marginal cost of producing that cup. When the market price of tea is \$1.75, Heavenly receives producer surplus of \$0.75 on the first cup (the area of rectangle A), \$0.50 on the second cup (rectangle B), and \$0.25 on the third cup (rectangle C). In panel (b), total producer surplus is equal to the area above the supply curve and below the market price, shown in red. 8

5 Consumer Surplus and What Consumer Surplus and Measure Consumer surplus measures the benefit to consumers from participating in a market rather than the total benefit. Consumer surplus in a market is equal to the total benefit received by consumers minus the total amount they must pay to buy the good or service. Similarly, producer surplus measures the benefit received by producers from participating in a market. Producer surplus in a market is equal to the total amount firms receive from consumers minus the cost of producing the good or service. 9 The Efficiency of Competitive Markets 4.2 LEARNING OBJECTIVE Understand the concept of economic efficiency. Marginal Benefit Equals Marginal Cost in Competitive Equilibrium FIGURE 4-5 Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium In a competitive market, equilibrium occurs at a quantity of 15,000 cups and a price of \$2.00 per cup, where marginal benefit equals marginal cost. This is the economically efficient level of output because every cup has been produced where the marginal benefit to buyers is greater than or equal to the marginal cost to producers. 10

6 The Efficiency of Competitive Markets 4.2 LEARNING OBJECTIVE Understand the concept of economic efficiency. Economic Surplus FIGURE 4-6 Economic Surplus Equals the Sum of Consumer Surplus and The economic surplus in a market is the sum of the blue area, representing consumer surplus, and the red area, representing producer surplus. The sum of consumer surplus 11 The Efficiency of Competitive Markets 4.2 LEARNING OBJECTIVE Understand the concept of economic efficiency. Deadweight Loss The reduction in economic surplus resulting from a market not being in competitive equilibrium. 12

7 The Efficiency of Competitive Markets 4.2 LEARNING OBJECTIVE Understand the concept of economic efficiency. Deadweight Loss FIGURE 4-7 When a Market Is Not in Equilibrium, There Is a Deadweight Loss Economic surplus is maximized when a market is in competitive equilibrium. When a market is not in equilibrium, there is a deadweight loss. When the price of chai tea is \$2.20, instead of \$2.00, consumer surplus declines from an amount equal to the sum of areas A, B, and C to just area A. Producer surplus increases from the sum of areas D and E to the sum of areas B and D. At competitive equilibrium, there is no deadweight loss. At a price of \$2.20, there is a deadweight loss equal to the sum of areas C and E. 13 The Efficiency of Competitive Markets 4.2 LEARNING OBJECTIVE Understand the concept of economic efficiency. Economic Surplus and Economic Efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum. 14

8 Government Intervention in the Market: Price Floors and Price Ceilings 4.3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. Price Floors: Government Policy in Agricultural Markets FIGURE 4-8 The Economic Effect of a Price Floor in the Wheat Market If wheat farmers convince the government to impose a price floor of \$3.50 per bushel, the amount of wheat sold will fall from 2.0 billion bushels per year to 1.8 billion. If we assume that farmers produce 1.8 billion bushels, producer surplus then increases by the red rectangle A which is transferred from consumer surplus and falls by the yellow triangle C. Consumer surplus declines by the red rectangle A plus the yellow triangle B. There is a deadweight loss equal to the yellow triangles B and C, representing the decline in economic efficiency due to the price floor. In reality, a price floor of \$3.50 per bushel will cause farmers to expand their production from 2.0 billion to 2.2 billion bushels, resulting in a surplus of wheat. 15 Making the Connection Price Floors in Labor Markets: The Debate over Minimum Wage Policy 4.3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. YOUR TURN: Test your understanding by doing related problem 3.12 at the end of this chapter. 16

9 Government Intervention in the Market: Price Floors and Price Ceilings 4.3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. Price Ceilings: Government Rent Control Policy in Housing Markets FIGURE 4-9 The Economic Effect of a Rent Ceiling Without rent control, the equilibrium rent is \$1,500 per month. At that price, 2,000,000 apartments would be rented. If the government imposes a rent ceiling of \$1,000, the quantity of apartments supplied falls to 1,900,000, and the quantity of apartments demanded increases to 2,100,000, resulting in a shortage of 200,000 apartments. Producer surplus equal to the area of the blue rectangle A is transferred from landlords to renters, and there is a deadweight loss equal to the areas of yellow triangles B and C. Don t Let This Happen to YOU! Don t Confuse Scarcity with a Shortage YOUR TURN: Test your understanding by doing related problem 3.16 at the end of this chapter. 17 Government Intervention in the Market: Price Floors and Price Ceilings 4.3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. Black Markets A market in which buying and selling take place at prices that violate government price regulations. 18

10 Government Intervention in the Market: Price Floors and Price Ceilings 4.3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. The Results of Government Price Controls: Winners, Losers, and Inefficiency When the government imposes price floors or price ceilings, three important results occur: Some people win. Some people lose. There is a loss of economic efficiency. 19 Government Intervention in the Market: Price Floors and Price Ceilings 4.3 LEARNING OBJECTIVE Explain the economic effect of government-imposed price floors and price ceilings. Positive and Normative Analysis of Price Ceilings and Price Floors Whether rent controls or federal farm programs are desirable or undesirable is a normative question. Whether the gains to the winners more than make up for the losses to the losers and for the decline in economic efficiency is a matter of judgment and not strictly an economic question. 20

11 The Economic Impact of Taxes 4.4 LEARNING OBJECTIVE Analyze the economic impact of taxes. The Effect of Taxes on Economic Efficiency FIGURE 4-10 The Effect of a Tax on the Market for Cigarettes Without the tax, market equilibrium occurs at point A. A \$1.00-per-pack tax on cigarettes will cause the supply curve for cigarettes to shift up by \$1.00, from S 1 to S 2. The new equilibrium occurs at point B. The price of cigarettes will increase by \$0.90, to \$4.90 per pack, and the quantity sold will fall to 3.7 billion packs. The tax on cigarettes has increased the price paid by consumers from \$4.00 to \$4.90 per pack. Producers receive a price of \$4.90 per pack (point B), but after paying the \$1.00 tax, they are left with \$3.90 (point C). The government will receive tax revenue equal to the green shaded box. Some consumer surplus and some producer surplus will become tax revenue for the government and some will become deadweight loss, shown by the yellow-shaded area. 21 The Economic Impact of Taxes 4.4 LEARNING OBJECTIVE Analyze the economic impact of taxes. Tax Incidence: Who Actually Pays a Tax? The actual division of the burden of a tax between buyers and sellers in a market. 22

12 The Economic Impact of Taxes 4.4 LEARNING OBJECTIVE Analyze the economic impact of taxes. Tax Incidence: Who Actually Pays a Tax? Determining Tax Incidence on a Demand and Supply Graph FIGURE 4-11 The Incidence of a Tax on Gasoline With no tax on gasoline, the price would be \$3.00 per gallon, and 144 billion gallons of gasoline would be sold each year. A 10-cents-per-gallon excise tax shifts up the supply curve from S 1 to S 2, raises the price consumers pay from \$3.00 to \$3.08, and lowers the price sellers receive from \$3.00 to \$2.98. Therefore, consumers pay 8 cents of the 10-cents-per-gallon tax on gasoline, and sellers pay 2 cents. 23 Solved Problem 4-4 When Do Consumers Pay All of a Sales Tax Increase? 4.4 LEARNING OBJECTIVE Analyze the economic impact of taxes. YOUR TURN: For more practice, do related problem 4.5 at the end of the chapter. 24

13 The Economic Impact of Taxes 4.4 LEARNING OBJECTIVE Analyze the economic impact of taxes. Tax Incidence: Who Actually Pays a Tax? Does It Matter Whether the Government Collects a Tax from Buyers or Sellers? FIGURE 4-12 The Incidence of a Tax on Gasoline Paid by Buyers With no tax on gasoline, the demand curve is D 1. If a 10-cents-per-gallon tax is imposed that consumers are responsible for paying, the demand curve shifts down by the amount of the tax, from D 1 to D 2. In the new equilibrium, consumers pay a price of \$3.08 per gallon, including the tax. Producers receive \$2.98 per gallon. This is the same result we saw when producers were responsible for paying the tax. 25 Making the Connection Is the Burden of the Social Security Tax Really Shared Equally between Workers and Firms? 4.4 LEARNING OBJECTIVE Analyze the economic impact of taxes. YOUR TURN: Test your understanding by doing related problem 4.6 at the end of this chapter. 26

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